Market Economics | Interest Rate Strategy - BNP PARIBAS ...

Market Outlook
The major developments in advanced country bond markets have centred
on the eurozone, where peripheral tensions remain and where Trichet has
taken a more hawkish tone.
Portugal’s tensions
probably not over
A more holistic solution
will come in the eurozone,
but when?
The European authorities seem to have realised that the piecemeal
approach to dealing with the crisis in the peripherals is not working and
something more holistic is required. While Portugal‘s auctions went well this
week, the underlying pressure remains. With a current account deficit of
almost 10% of GDP last year, domestic savings are insufficient to meet the
Portuguese government’s financing needs. Hence, there is a need for
inflows from nervy foreigners. Despite the auction, market belief in Portugal’s
ability to evade the EFSF remains weak. If uncertainty about Portugal
increases then there will be spillovers to Spain and Belgium. If Portugal does
go into the EFSF, the “who’s next?” mentality will affect them also.
Hence the talk of increasing the EFSF’s resources (which it would only need
if the strains went beyond Portugal) and remit, perhaps to buy existing bonds
also. We welcome this. The European crisis could in theory result in
integration or disintegration. We have always been in the former camp and it
seems that we are edging towards that. However, the path will not be
smooth. More funds for support means more conditionality and, for
borrowers, less national fiscal (and therefore political) sovereignty. What are
the modalities of that and how is the national political will for that to be
mobilised? Maybe only through repeated crises. Thus, while this week’s
news has been more positive, we are far from out of the woods.
When we do see a more comprehensive and coherent framework, it will not
be good news for core bonds: a) the flight-to-quality bid will be reduced; b)
Germany’s prospective fiscal burdens will rise; and c) there will be one less
restraint on the ECB as regards unconventional measures and rates.
Trichet’s inflation concerns
increase
Trichet’s stance in the press conference was surprisingly hawkish given the
context of stress in the periphery. The emphasis was on inflation and shows
clearly that the ECB’s risk assessment on inflation is shifting, reflecting
higher global prices and upward surprises to activity (see Brazil focus for an
illustration of why EM inflation is becoming troublesome). His comment that
the ECB is never pre-committed not to raise rates when inflation looks set to
rise in the immediate months ahead can only be seen as hawkish. Further, it
stands in contrast to the Fed’s undertaking to keep rates exceptionally low
for an “extended period”. This suggests quite clearly that the ECB will move
rates higher sooner than the Fed, as EUR/USD was not slow to price, the
reason for that being very different inflation assessments. It is likely in the
period ahead that the market will price in more and earlier ECB tightening.
While we see an important obstacle to that being likely peripheral tensions, it
is clear which way the market wind is blowing.
In the bond markets, the negative tone could lose momentum, especially in
the US, after this week's auctions. Statistically, there is a decent bias for
Treasuries to richen in the days following the 30y auction, perhaps because
the auction set-up process is over. However, near-term momentum could
still be driven by events in Europe.
Fed to buy more than
expected this month
The Fed announced the QE2 buyback schedule for the coming month, and
the size of USD 112bn was higher than most street estimates of around
Paul Mortimer-Lee 13 January 2011
Market Mover 2 www.GlobalMarkets.bnpparibas.com